Interest Rates, Bonds & Inflation Real vs. Nominal Interest Rates

Bonds Bonds: are a loan to a Gov’t or business where you earn interest every year until you are paid back. If the company goes bankrupt => you usually will not be paid back! You buy a Bond U.S. Gov’t 5-Year Bond $1,000,000 cash Gov’t pays you 2% interest per year $20,000 per year Plus $1 million in 5 years $1.0 million turns into $1.1 over 5 Years

Bond Prices U.S. Government sells bonds to “borrow money” Bond prices move inversely with interest rates! Interest rates ↓ => Bond Prices ↑ You buy a Bond U.S. Gov’t 5-Year Bond $1,000,000 cash $20,000 interest per year

Interest Rates Reflects the cost of borrowing money (or benefit of saving it!) There are short term & long term interest rates Low interest rates are critical for a healthy economy (GDP) As interest rates ↑ => cost of borrowing money ↑ => Investment (I) ↓

Short Term Interest Rates The Federal Reserve only “controls” short term interest rates Used by banks & currently = 0.0% Federal Funds Rate changes over time to regulate GDP & inflation

What does the Fed policy do to savers? Janet Yellen leaves rates at ZERO What does the Fed policy do to savers? 0.0%

Long Term Interest Rates Long term interest rates are determined by inflation expectations Currently = 1.50% (10-year government bond) As Expected Inflation ↑ => long term interest rates ↑ Bond prices move inverse to interest rates. bond prices ↓ => interest rate ↑

Investments & Inflation Inflation directly affects your real return on any investment If a bond pays 2.5% interest, what is your real return? “It Depends” on the rate of inflation!

Adjusting Interest Rates for Inflation Nominal Interest Rate = Real Interest Rate + Expected Inflation Reworking above formula: Real = Nominal – Expected Inflation 10-year Gov’t Bond Purchase $1,000,000 Nominal Interest Rate 2.50% Nominal dollars per year: $25,000 (interest per year) In 10-years: $1,000,000 principal paid back If expected inflation = 2.0%: The real interest rate is 0.5% (2.5% - 2%) Purchasing Power ↑ $5,000 per year

Interest Rate Test